London office space remains in high demand
(Archived)

While London’s residential property prices may be making the headlines in the UK, it is the capital’s seemingly evergreen office rental market that continues to attract investors from home and abroad. This trend looks set to endure throughout the second half of 2015, according to Alan Supple, managing director, global real estate securities at BNY Mellon Investment Management EMEA Limited (as UK representative of CenterSquare Investment Management1).

While the broader UK property market is still waking up from its post-financial crisis reverie, the same can’t be said of London. The epicentre of, and engine behind much of the UK’s economic recovery, the sector continues to attract significant demand and foreign direct investment. “For many, London property is seen as a haven for capital preservation – given the falling yields and rising values and demand in evidence, it’s not hard to see why,” says Supple.

While London residential property has bounced back sharply from its mid-crisis hiccups, what is the state of the city’s office rental market? “It seems to be flourishing. Since the financial crisis, it has taken some time for momentum to pick up and for developers to press ahead with plans; the UK’s improving economic situation has certainly helped. So too has London’s position as a bona fide ‘global’ hub,” he explains.

The office rental market has also been bolstered by the legacy of the global financial crisis. The current low office vacancy level, at 8.2% in September 2014, according to Savills Research, is a direct consequence of the limited number of development starts between 2008 and 2011. Falling tenant demand, non-existent development funding and the prevalence of office to residential conversions all played a part. But as these trends gradually reverse, office vacancy rates in the capital look set to fall further. Indeed, by 2019 London will have one of the lowest office vacancy rates among the world’s leading cities, at 4.4% (lower than Hong Kong’s predicted 4.5%), according to Knight Frank’s Global Cities Report.

Moving out

Since the peak of the financial crisis there have also been some very interesting occupier sector shifts. For example, from 8% in 2007, the tech, media and telecom (TMT) sector amounted to some 34% of London office rental space in 2013, according to Deloitte. This sharp rise has been the result of a combination of TMT companies’ desire for expansion but also the creation of tech and digital offshoots of large corporates. Much of this growth has been on the fringes of the City of London and West End. The magnetic force of large tech players setting up camp has also been a factor, says Supple. “Look, for example, at Kings Cross and the arrival of Google. Two million square foot of development is now underway and this doesn’t just involve tech firms; segments that overlap are also being drawn to the area.”

Meanwhile, to the east of the City, Amazon is moving its UK headquarters to a 431,000 square foot site at Bishopsgate – this too is expected to draw huge development from other sectors. “It’s particularly interesting to see this kind of development, by non-financial firms, on the doorstep of London’s financial centre,” he adds. While Google has essentially bought its building at Kings Cross (it has a 999-year lease), this is an exception to the general rule. “In the main, most of the expansion in the tech space is through traditional office letting,” says Supple. “We are also seeing a lot more creativity from office landlords. Indeed, much of the growth near Old Street and the so-called ‘Silicon roundabout’ has come about because landlords have been much more flexible in terms of leases, use of space, energy efficiency and affordability – it is no wonder start-ups have flocked to this area. Landlords have done much to reinvigorate what had become obsolete space.”

However, this reinvigoration will take time. While landlords and developers have reacted to the high demand, the lack of supply looks unlikely to improve in the near term given office refurbishment and development programmes typically take around 18 to 30 months to complete.

While the TMT sector has taken up some slack outside of core central London, there is plenty of demand from other business segments too, according to Supple. “Emerging from the economic downturn, London had limited supply and rapidly recovering demand. What we are seeing, however, is a move away from speculative construction. Risk appetite has waned and development finance has yet to really wake-up from its post-crisis lull. So, we are now generally seeing around one third of a development project pre-let before a shovel has even entered the ground.” A degree of caution looks set to remain in place.

Sturdy foundations

Against this high-demand backdrop, rents are unsurprisingly holding up very well. “In the City we are seeing some leases signed at £70 per square foot – back to 1980s peak levels – but within the prime space there’s plenty of scope for further rental growth in the year ahead. Given the level of demand, market expectations of 5%-6% rental growth over the coming few years seem reasonable, with higher single-digit growth in the most supply-squeezed areas such as the West End,” he suggests. “However, for the second half of 2015 it will be interesting to see how much new supply in the fringe areas – the likes of ‘Silicon roundabout’, Canary Wharf, Southwark, Paddington and King’s Cross – enters the pipeline and how this affects demand in the core areas. These are certainly areas to keep an eye on,” Supple adds.

Further down the line, Crossrail – a new high frequency, high capacity railway for London and the South East that dissects the capital – will complete in 2017 and this is already drawing office rental demand to new areas along the line. “Canary Wharf, Broadgate, the core West End and Paddington all sit on the Crossrail corridor but anything within a half-mile radius is expected to be positively affected by the so-called ‘Crossrail halo’", he explains.

Discussion rightly continues over the sustainability of this demand and a lot of this comes back to the strength of the UK economy as a whole; economic strength is needed for long-term plans and developments to be initiated and pushed through. “But the outlook for London office rentals over the next few years looks strong; this investment story certainly still has some way to go,” concludes Supple.

Source: Deloitte, July 2014

1.Investment Managers are appointed by BNY Mellon Investment Management EMEA Limited ("BNYMIM EMEA") or affiliated fund operating companies to undertake portfolio management activities in relation to contracts for products and services entered into by clients with BNYMIM EMEA or the BNY Mellon funds.